Your credit score reflects how well you manage your debts, so it’s reasonable to assume that paying off your student loans will improve it. This is mostly true. However, the effect of paying off your student loans isn’t perfectly straightforward.
In many cases, you’ll actually see a small (but temporary) drop in your credit score when you finish paying your loans off. Your score will quickly recover, and in the long term, the effect will be positive. Read on to find out why this happens.
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How does paying off student loans increase your credit score?
At its core, credit scoring is very simple. FICO and VantageScore (the two main scoring models) both reward you for having a well-established history of responsible credit use. “Responsible” means taking care not to overextend yourself financially and always paying your bills on time.
When you take out an installment loan (such a student loan) and make regular payments on it, it demonstrates that you’re managing your credit responsibly, which is good for your score.
Paying your student loans benefits the following factors that affect your credit score:
- Payment history: Your payment history is a record of your payments and whether you made them on time or not. Keeping your loan “paid as agreed” (aka not missing payments) will build your payment history and improve your credit score.
- Amounts owed: “Amounts owed” is FICO’s name for the scoring factor that looks at how much credit you’re actively using—in other words, the size of your debts. The more of your loan you pay off, the less credit you’ll be using and the better your score in this category will be.
- Credit age: Also known as the length of your credit history, this measures how old your various loans and credit accounts are. Paying your student loan won’t directly benefit this factor, but the longer your student loan remains on your credit report, the more it will age, which will improve your score.
The upshot is that over the lifetime of your loan, you’ll contribute to all three scoring factors, benefitting your credit score.
However, it’s possible that when you actually finish paying your student loan off, you’ll see a small drop in your credit score. This catches many people by surprise, but it makes sense if you understand how the models calculate your credit score. We’ll explain this in detail below.
How can paying off student loans hurt your credit score?
Sometimes your credit score can drop right after paying off debt. If this seems counterintuitive to you, you’re not alone—it’s one of the more surprising aspects of the credit scoring models.
There are a couple of reasons why your score might have dropped after paying off your student loan:
Your student loan was your only installment loan
The variety of different types of credit accounts you have (known as your credit mix) has a small influence on your credit score. Both scoring company’s models reward you for having a diverse blend of credit accounts that features both credit cards and loans.
If you have no other loans (e.g., a mortgage or auto loan), paying off your student loan will reduce the diversity of the open accounts in your credit file, causing a minor dip in your credit score.
You increased your debt-to-credit ratio
As mentioned, the credit scoring models look at the amount you owe (aka your balance) on each open credit account that you have.
You sometimes receive a small boost to your score from having a loan that’s mostly paid off. When you clear the debt completely and the credit account closes, you’ll lose this boost, which will slightly depress your score.
This is especially likely to happen if your balances on your other credit accounts are relatively high. When you pay off your student loan, your average debt-to-credit ratio (how much you currently owe versus the total size of your credit accounts) will significantly increase, hurting your credit score. 1
How to minimize the damage to your credit from paying off your student loans
By practicing good credit-building habits, it’s possible to mostly (although not entirely) avoid the dip in your credit from clearing your student loan debt. Just do the following:
- Open another installment loan: If you have another installment account, you’ll be protected against the hit to your credit mix from paying off your loan. In general, it isn’t a good idea to open a loan just for the sake of bolstering your credit mix, but some credit unions offer special credit-builder loans that are specifically designed for this purpose. Search for credit unions in your area and call to see if they offer this option.
- Keep your spending low: Try to maintain low balances on your credit cards (under 10% of your credit limit if you can help it). If your debt-to-credit ratio is relatively low, paying off your student loan won’t affect it as much, and the hit to your credit score will be much smaller.
Should you postpone paying off your student loan to protect your credit score?
No, you shouldn’t avoid paying off your student loan just to protect your credit score. Keeping your loan open will cause you to pay more in interest and might entail missing payments.
This isn’t a worthwhile trade. Making late payments on your student loan will harm your credit score much more than paying it off. If you stop paying your loan entirely, it will lead to even more serious derogatory marks on your credit report, such as charge-offs or student loan collections.
Don’t worry too much about the hit to your credit score that paying off your loan will cause—it probably will be relatively small and won’t last very long. It’s more important to stay on top of your debts.
Are there any benefits to paying off your student loans early?
There are benefits to paying off any debt early, including student loans. Doing so won’t directly benefit your credit score, but it will improve your financial health in other ways.
The most obvious advantage is that you’ll save money that otherwise would have accrued in the form of interest.
Beyond that, paying off your student loans early will also allow you to set new financial goals, free up more of your monthly income, and help you achieve a lower debt-to-income ratio so that you can qualify for new loans in the future, such as auto loans or mortgages.
How to pay off student loans more quickly
If you want to pay off your student loans faster, here are some good ways to start:
- Making more than the minimum payment: Paying more than the minimum amount required by your lender each month will reduce your balance more quickly and minimize the amount of growth in the debt due to interest.
- Refinancing: Taking out a new loan to refinance your current student loans may help you pay down your loans quicker if you have private student loans and you can qualify for a lower interest rate. However, do your research first to ensure you don’t end up with a longer loan term or higher overall interest rate.
- Debt consolidation: If you have multiple loans with high interest rates or you’re also trying to get out of credit card debt, then using a new loan to consolidate your debts may reduce your monthly payments and help you pay off your student loans more quickly.
All in all, paying off your student loans as soon as possible will benefit your finances and provide you with a strong foundation for accessing and managing new credit accounts, even if it temporarily lowers your credit score by a few points.
